Wizards and gods

April 25, 2018

Market Summary – 1st Quarter, 2018

“If you wish to make an apple pie from scratch, you must first invent the universe.”

~Dr. Carl Sagan

These three great innovative thinkers, and others like them, have opened whole new worlds to us. Astrophysicist Dr. Carl Sagan is fondly remembered for helping explain “The Cosmos” in layman’s terms, and is renowned for his landmark research on the possibilities of extraterrestrial life. The late Stephen Hawking was a theoretical physicist who made great leaps in our understanding on the origins of the universe and the nature of black holes. Dr. Michio Kaku, also a theoretical physicist, is co-founder of string field theory, a subset of string theory that assumes there are multiple universes and dimensions beyond what we know. Dr. Kaku’s work is breaking new ground in concepts that may ultimately make it possible for us to become interplanetary travelers. The amazingly imaginative minds of these individuals, and many other incredibly intelligent and creative people, help spur the innovation that continues to power our society and our world. As consumers, we benefit every day from their findings. As investors, we’re fortunate to have the opportunity to participate and profit from it.

Our stunning present

The discoveries of people like Drs. Sagan, Hawking, Kaku, and other innovative thinkers may often seem beyond us. We might describe them as “wizards and gods,” (in the mythological sense). For example, Dr. Kaku believes it is possible to conceive of intergalactic space travel not unlike what we’ve seen in Star Wars or Star Trek. As for innovative advances with more immediate impact, he notes that significant progress is being made to find ways to slow down the aging process and extend life. In the not-so-distant future, people could commonly live well beyond 100 years – and be in better physical and mental condition. In fact, the efforts to, in essence, put a pause button on the aging process are closely linked to dreams of exploration to far-off galaxies, as those missions would entail travel time equivalent to several lifetimes.

Tom Cheney/The New Yorker Collection/The Cartoon Bank

The truth is, thanks to creativity and innovation, we’re all wizards and gods. All of us are beneficiaries of the fantastical thinking that has occurred in the past. Consider the tremendous changes we’ve seen in our lifetimes, and those of our parents and grandparents. As Dr. Kaku points out, as recently as the year 1900, the average person lived to be 49 years old, and traveled by horse drawn wagon. Undertaking a long journey was fraught with peril, and there was a high likelihood you wouldn’t return safely. Long distance communication was primarily achieved by yelling out the window or via carrier pigeon. Did the average person in 1900 even conceive that in less than a century, we’d be routinely flying across oceans on airplanes, or that we would be able to talk to or video conference with someone halfway around the world from anywhere with our very affordable mobile device? And imagine that in just a few more years, we could carry on that conversation while our autonomous vehicle drives us to the corner drug store to receive a single flu shot that could protect us over the course of our lives. Had our ancestors witnessed that, no doubt they would consider us to be wizards and gods.

What could happen in the next century? Given the track record of recent times, particularly in the most recent generations, is it reasonable to think that the world will be so far beyond our imagination that we would look on our descendants and the tools of their everyday lives, and label them as wizards and gods?

In short, it’s a big cosmos out there, with infinite possibilities. It is easy to lose that perspective in the hectic course of our day-to-day lives and the headline events that bombard us.

An era of distraction

It is fair to say that the last year-and-a-half could be described as “eventful.” To this point in 2018, the market has certainly viewed things that way, with wild gyrations occurring on a seemingly regular basis. That doesn’t always make it easy for investors to think about future opportunities.

The market increasingly seems to be distracted by external headline events, from Fed rate hikes to trade wars, from diplomatic scuffles to immigration anxieties, from cabinet turnover to twitter tantrums. With so many negative headlines, other news tends to get lost. How much thought have you given to these realities of our world today?

Unemployment is at its lowest level in years, with an average of 200,000 new jobs being created per month1, and prospects for meaningful wage growth on the rise.

New tax cuts are creating an opportunity for more money to flow into the economy.

Most, if not all, major developed markets in the world are enjoying synchronous economic growth for the first time since before the Great Recession.

The U.S. economy is showing signs of finally reaching escape velocity, with growth consistently near the 3% mark.

Corporate profits are growing, with earnings of the S&P 500 gaining 17% in 2017. Even better, earnings are expected to grow at a faster rate in 2018.

The fundamental underpinnings of the economy and markets are strong. This is not to say that there aren’t serious issues in the country or around the world. There are significant challenges, as there always have been through time. If there is a lesson we can take from history, it is that future advancements, brought about by continued innovation, will ultimately have a far greater long-term positive impact on our society and markets than any of the seemingly thorny headlines that we are confronted by. As investors, we remain firmly focused on the opportunities that innovation continues to create, while leaving the distractions to others.

Today’s wizards and gods

Many have become jaded and skeptical about the times that we live in and where we might be headed. Market volatility contributes to these unsettling feelings. But that’s missing the bigger picture. It is important to appreciate the wonders that await us in the future. Despite all of the distractions, innovation marches on. We believe that the tremendous advances we have witnessed in the past two centuries will continue at the same, or even a more torrid, pace.

Given that your mobile phone possesses computing power that surpasses what it took to get Apollo 11 to the moon a half-century ago, what is possible in the future? Dr. Kaku and many others are convinced that we will develop the technologies to actually make settlements on Mars and other intergalactic destinations. That may sound like the makings of science fiction to many of us, but so did Leonardo da Vinci’s futuristic drawings during the Renaissance and Jules Verne’s stories of a little more than a century ago.

These new “space age” possibilities don’t, by themselves, represent actionable investment opportunities today. But many of the companies making these stepping stone innovations leading us down this ambitious path are worth considering.

To cite a cliché, the future is today. Innovative companies are opportunistically using their own creativity and capabilities to build the products and services that will cross new technological thresholds. At the center of it all are continued astounding advances in science.

The MPMG All-Cap Value portfolio contains a number of firms that we believe are well positioned due in large part to their innovative bent. Here are just five examples across a broad range of industries:

5 INNOVATIVE STOCKS IN MPMG’s PORTFOLIO:

3M (MMM) – one of Minnesota’s, and the world’s, great innovators invented the fabric used in space suits and continues to create and market a broad range of products engineered for aviation and space exploration. Their coatings, glass bubbles, and composite resins help optimize product design and minimize the weight of many products.

Qualcomm (QCOM) – a world leader in next generation wireless technologies, its patents serve as the foundation for wireless communicattions. It’s at the forefront of the emerging 5G wireless technology.

Corning (GLW) – an innovator in glass science, ceramics, clean air technologies, and optical physics. Corning’s advanced optics are a key contributor to the groundbreaking Hubble space telescope and the soon to be launched James Webb space telescope, which will give us a better understanding of where future exploration may go.

Parker-Hannifin (PH) – a diversified and innovative company that, among other things, has made major contributions to spacecraft since the earliest days of the U.S. space program. The firm’s valves, pumps, actuators, electronic controllers, and digitally driven technologies are changing the face of assembly lines, particularly in the aerospace industry.

International Business Machines (IBM) – their technology was involved in the first lunar landing and has continued to play an important role in space explorations. IBM is a leader in the adoption of space technologies for science, communications, and business. Later this year, it is expected that a floating robot equipped with IBM’s Watson artificial intelligence technology will assist scientists deployed aboard the international space station. Another example of IBM expertise is the emerging block chain technology that is driving cryptocurrencies.

What’s innovation got to do with value investing?

As value investors, our focus is on finding companies trading at reasonable/discounted valuations at the forefront of where the economy or specific industries may be headed. This has little to do with the very real, but often dramatized, news that may move the markets on a particular day. It is all about being in tune with the future and seeing the big picture. Because we approach the market as generalists, we keep our eyes open to understanding how the emergence of some innovations may affect other businesses, sometimes even those that don’t appear to be closely related to it.

Value investing is often perceived as identifying stodgy, but solid, companies that are underappreciated by investors; and therefore, available at bargain prices. In our world, the focus is on inexpensive companies that are well positioned to capitalize on market opportunities, and that are able leverage innovation to grow their profits.

But innovation without consideration to valuation is, in our opinion, risky. Today, some of the most celebrated and “innovative” companies are the so-called FANG stocks (Facebook, Amazon, Netflix, and Google’s parent holding company, Alphabet). These may be wonderfully innovative companies that are changing the world, but by most valuation metrics, they are overpriced and not sound investments, in our opinion. Consider their valuation in terms of one of the popular valuation metrics, the price/earnings ratio. The average price/earnings ratio for the group of four FANG stocks is 134.6x earnings. By comparison, the average P/E ratio for the five aforementioned stocks held in our portfolio is just 16.8 x².

Paying the right price is an effective way to make innovation work for investors. Investors are too often “late to the party” for these high-flying stocks and can easily be hurt either by a general downdraft in the markets (which happens from time-to-time) or by specific events that affect a company (in recent weeks, Facebook and Amazon have experienced this). By being invested in these stocks when they carry lofty valuations, investors often assume significant and unnecessary risk in the quest to capitalize on innovation.

An important lesson for investors to remember is that innovation is not limited to momentum stocks that are expensively valued. We are as excited as anybody about the possibilities that innovation creates. Firms on the cutting edge of the kind of innovation that contributes to the advancement of civilization have consistently been part of our portfolio over the years. There are different ways to invest in innovation. For us, the difference is price. The key to our success is maintaining discipline in an effort to avoid overpaying for the innovative companies that we find.

Bumpy rides, smooth landings

The purpose of this letter is not to paint an unrealistically rosy picture of our world. We’re fully aware that today’s geo-political framework presents any number of notable challenges. Troubling headlines can drive emotions of fear and greed. This may continue to lead to bumpy times ahead for investors, similar to what we’ve experienced so far this year.

Yet we also firmly believe that we live in prosperous, and in many ways wondrous, times. For the near term, we agree with projections of continued strong growth in corporate earnings, which is ultimately the measure that drives stock performance. Over the longer run, we are convinced that innovation will continue to lead humanity to becoming “wizards and gods” in the eyes of previous generations. We’ve been learning more about the vision of Dr. Kaku, and find his insights, which range from the big picture of the universe and beyond, to company-specific products of the future, to be refreshing and enlightening. We hope to write more about him and his unique perspective in the near future as we continue to emphasize the power of innovation. The proven ability to leverage innovation as a springboard to future success is an important characteristic of effective investing and a component of many of the companies that we invest in on behalf of our clients. Any number of companies represented in the stock market today can lay claim to being innovative. Some are well known; others are not. Our job continues to be to discover those we feel offer a prosperous investment opportunity . . . but at the right price.

Although the information in this document has been carefully prepared and is believed to be accurate as of the date of publication, it has not been independently verified as to its accuracy or completeness. Information and data included in this document are subject to change based on market and other condition. All prices mentioned above are as of the close of business on the last day of the quarter unless otherwise noted. Market returns discussed in this letter are total returns (including reinvestment of dividends) unless otherwise noted.

The information in this document should not be considered a recommendation to purchase any particular security. There is no assurance that any of the securities noted will be in, or remain in, an account portfolio at the time you receive this document. It should not be assumed that any of the holdings discussed were or will prove to be profitable, or that the investment recommendations or decisions we make in the future will be profitable. The past performance of investments made by MPMG does not guarantee the success of MPMG’s future investments. As with any investment, there can be no assurance that MPMG’s investment objective will be achieved or that an investor will not lose a portion or all of its investment.